Part 1 -What Should be Included in Your LLC Operating Agreement?September 13, 2018 | By Erik Lincoln
Operating Agreements in General
Operating agreements define the rights and obligations of the members of a limited liability company (“LLC”). For LLC’s formed in North Carolina, the North Carolina Limited Liability Company Act (the “Act”) provides that an operating agreement may be oral, in writing, or any combination thereof. While operating agreements may be oral, it is recommended that they be reduced to writing in order to minimize disputes and protect the expectations of the members.
Even for single member LLC’s we recommend that the operating agreement be reduced to writing. One of the main reasons why people set up businesses in entity form is to take advantage of liability protection. To maintain this protection, it is important to follow the formalities of the entity. While not having an operating agreement will not result in the loss of liability protection per se, it is one fact that could count against you if you are not following other formalities.
The terms of every operating are different. Those differences depend heavily on the type of business being operated, the management structure, the relationship of the members (are some investors while others are operating the business), and the tax classification selected for the LLC.
Operating Agreement Sections
The following are the ten most common sections found in an operating agreement.
- Formation of the LLC
- Management of the LLC
- Rights and Obligations of the Members
- Capital Contributions and Loans
- Transfer of Interest and Admission of Members
- Dissolution and Liquidation
A summary of each of these ten sections is provided below.
- Formation of the LLC – Almost all operating agreements provide background type information in the first section of the operating agreement. This information will often include, the name of the LLC, when and where the LLC was formed, what the LLC’s purpose is, where the principal office is, who the registered agent is, and what the term of the LLC is (i.e., how long it will remain operating). This information is not necessary for a valid operating agreement, but it is useful background information. One important term you may find here is how the LLC will be classified for tax purposes, whether it be will treated as a disregarded entity (i.e., an LLC with one owner), partnership, S Corporation, or C Corporation.
- Management of the LLC – This is obviously one of the more important sections of the operating agreement, whether you are a member or whether you are a third party trying to determine who has the ability to act for the LLC. The two most common management structures for LLC’s are referred to as “member-managed” and “manager-managed”. When an LLC is member-managed, there are no managers, and all decisions are generally made by a majority vote of the LLC members, where each member has a vote proportionate to their ownership. If an LLC is manager-managed the LLC is governed by one or more managers (who may or may not also be members). In manager-managed LLCs, decisions are often made by a majority vote of the managers. These are the most common management structures, but there are many possibilities. For instance, the LLC could be managed by officers, similar to a corporation.
- Rights and Obligations of the Members – If an LLC is member managed, this section of the operating agreement provides details of how the members will govern, how to take a vote, and how much of a vote each member has. If an LLC is manager-managed, this section will state that the members do not have any voting power, except that their approval may be needed for certain highly important decisions such as, to amend the operating agreement, to accept a new member, whether to borrow money, and whether to sell certain of the LLC’s assets, etc…
- Capital Contributions and Loans – Most members have a good idea of the capital they need at the inception of their LLC. These details are stated here and often in a schedule to the operating agreement. But, one of the most important aspects of this section is to help the members define how they will seek capital in the future should the business need it. Will the operating agreement provide that the members are obligated to infuse additional when called upon to do so (i.e., capital-call), or will the operating agreement only permit capital calls if all members agree? Also, if a member is permitted to make additional capital contributions while other members do not, what impact will that additional capital have on the member’s rights – will all ownership percentages stay the same or will they change. Further, this section should speak to the ability of the LLC to borrow from either a bank or a member. If an LLC can borrow from a member, it is common to state in the operating agreement how the interest rate (among other loan terms) will be determined.
In Part 2 of this article, I will discuss the remaining sections of an LLC operating agreement.